Simple Manual Trading System Part 5 - Emotions in trading Vs. Trading by emotions
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Although we covered all basic technical aspects of creating a simple manual trading system, we still haven't mentioned a very important aspect of using our system. One trader told me that half of Forex trading is about observing own emotions. It is because emotional and intuitive reactions may devastate even the best system in the world. Something similar to the human being the weakest link. In this last article of the series I'd like to offer you some insights on psychology in trading.
During our evolution process, nature created a set of automated mechanisms in every living creature aimed at maximization of chances to survive.Therefore, when we are in danger we receive an adrenaline shot and our brain functions switch to reflex reaction mode. Our body prepares to physical engagement turning off unnecessary thinking. It works well when you need to fight a lion or run from burning building. But on the other hand it won’t help you when you need to solve a riddle quickly - even if it could save your life.
Obviously your life isn't in danger when trading Forex, but unfortunately your brain reacts as if it was. The same evolution process taught us that gains are very good - gains are reward for proper behavior, gains makes you able to survive. Conversely, losses are very bad; they are threat to your existence. Actually, as proven by scientists, fear of losses comes from the same part of your brain as the fear of death. So both gains and losses are tied with very strong, atavistic emotions that come from the unconscious and as long as your system won't be a '100% holy grail', you won't be able to avoid fear or greed in your trading. So let's take a closer look at what exactly to expect while using our system.
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Fear is a required emotion in real life. Just imagine if people weren't afraid of doing dangerous things, their survival rate would be way lower than it actually is. We need fear to prevent us from doing stupid, irresponsible things, but sometimes we need to suppress it so it won't paralyze our decision process. It is normal that after some heavy loses you are afraid of entering trades and losing more, but on the other hand it won't lead you anywhere.
Greed is also good. Thanks to it you want to take efforts whenever you see possible gains. But too much greed may cause you trouble as it forces you not to think about good trading but profitable trading instead - and let's make it clear: good trading is profitable, profitable trading isn't necessarily good, and in longer run this difference becomes crucial.
Euphoria comes when your trading system has better days and you win most trades you are in a good mood most of the time. You may feel like market has no secrets for you, and you are an investment hero. Then you probably find yourself thinking about how much money will you make in close future. This can make you overconfident and inclined toward baring extra risk, but also you may downplay the market. This is when problems are about to begin.
Depression may hit when your good streak comes to an end and you didn't notice it yet, you are still in an excellent mood happy to take some extreme risk over next trades. As I mentioned before, every system has better and worse days. System with efficiency as high as 50% can have streaks of 9 or more losing trades. When you feel invincible having your account overleveraged, you will certainly feel lot of pain and fear in such nightmare streak of losers. Acting under such negative emotions result in few illogical and unreasonable mistakes, that are so often that they eventually became a rule. After first couple loses you feel anger because you've let most of your gains go. It's easy to trade with your gains and it's even easier to lose them. This anger makes people double their bets in order to regain loses quickly. This way you end up with increasing your risk at the beginning of troublesome period. You still feel like a FX hero, so what could go wrong? Such overconfidence makes traders unable to admit mistakes. People often want rather hold big losses against the market than admit that their investment decision was wrong and to take hit. Here is where hope steps in - while you read this you may think that it's all unreasonable, and in fact it is. People tend to set Stop Loss and instead of filling it when price goes against their trade, they withdraw it widening loss margin. This state of mind is similar to a charging bull - angry trader trying to offset losses in any possible way. I such cases market teach us a lesson, that there doesn't exist Stop Loss that is wide enough.
It is very difficult to handle our emotional side. Emotions are normal and needed in a real life, and it's quite hard task to get rid of them at the moment when you launch trading platform. Obviously you start trading with hope of some earnings - obviously nobody wants to lose money. Actually dealing with psychological side of trading requires lot of work and training. Professional traders who deals large amounts of cash terminates for couple of years before they are ready. But there are several ways from the system side, to make it easier to handle our emotions and to avoid tailspin within our account balance:
1) Always set Stop Loss on maximum level of 3% of your balance or less.
2) Never increase your risk over maximum level, i.e. by adding to a losing position.
3) Trade with predefined position size and increase it only after appropriate balance level is reached.
4) After few wins, take a rest for some time. Don't let euphoria to drive your trading.
5) After a few losses, take a rest till end of the day. Don't let your anger to gain control over your trading.
6) Don't stare on your equity number all the time. Excessive attention on it may cause unnecessary emotional attachment.
7) Observe your emotions and actions while being on the market. Find the point, where you have problems to emotionally withstand risk you've taken. Don't cross that boarder.
It's not that hard to notice, that most of points mentioned above require great discipline. To obey these rules you need to win with your natural reactions and force yourself to go against your strongest feelings. One trader told me, that to trade well, you need to learn to do things that are completely unintuitive. Also many traders admit, that very important moment in their trading was when they realized that the only thing they can control is maximum loss. You cannot control the market, but only your risk. You must remember that every time you enter any trade. Market does not care about you. It doesn't know where your positions are, how much money is in your account and why do you need extra money. Market will live it's own life with or without you. That's why trading the market is so much about trading yourself.
Finally, it's very important to filter the noise. If you have your system and made proper analysis with your best set of tools, don't mess it with other people's ideas or shouting press titles. It's not that you shouldn't track economic events or read market news. But you need to keep in mind that most of press' jabbering is only noise without real impact on market. On the other hand, other's people analysis may bring you some ideas, if you remember, that your system and your analysisare above all others, because your loses and gains are yours only.
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